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How Carpetright is looking to cover one big flaw

Carpetright’s store leases were a serious issue for the business back in 2014 and the terms of a new agreement with its creditors suggest they are likely to continue being so

05/07/2018

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

Carpetright has seen its share price fall so far over the last four and a bit years that it is now almost obligatory to talk in terms of the business being ‘floored’ or having the ‘rug pulled from underneath it’. Certainly we were not too proud to do so, here on The Value Perspective, when we wrote about the company’s plight, in Flaw covering, in December 2014.

Back then, we suggested the business had taken on too much debt in the form of its leasehold agreements and, no matter how cheap it appeared at first sight, its balance sheet was simply not robust enough to interest us as investors. At that point, Carpetright’s share price had all but halved since reaching a three-year high of 628.5p in April 2014 and yet it has kept on heading downwards. At the end of June, it stood at just 29p.

If it had been a US business, Carpetright could have looked to restructure its debts by filing for ‘Chapter 11’ bankruptcy protection and renegotiating all outstanding liabilities with its creditors. While this is not an option in the UK, a more diluted version of Chapter 11 known as a company voluntary arrangement or ‘CVA’ is – and Carpetright duly announced last week it had agreed just such a thing with its various landlords.

Does a CVA mean gloomy days ahead?

In recent years, a CVA – a legally binding agreement between a business and its creditors – has come to be seen as the route of choice for retailers struggling under the weight of existing leases. Creditors tend only to agree to one if they believe a business is genuinely on the verge of bankruptcy – and, of course, only time will tell if this CVA emerges as anything more than a temporary solution to Carpetright’s problems.

The omens, however, are not promising – the handful of listed companies we are aware of having entered into CVAs over the last decade, here on The Value Perspective, have nonetheless all ended up bust. Clearly where there is life, there is hope and Carpetright will do all it can to keep trading but ultimately, over the longer term, that will come down to improving its profitability.

The terms of the company’s CVA nod to that harsh reality, dividing its 400-odd leases into three categories, according to the strength of their rent-to-sales ratios. ‘Category A’ stores, which have a rent-to-sales ratio of around 15%, will continue on their existing lease terms while ‘Category B’ stores, which have a rent-to-sales ratio closer to 20%, will see rent reductions of between 30% and 50% for three years.

For their part, the least profitable ‘Category C’ stores, which have a rent-to-sales ratio of almost 30%, will see a 50% reduction in their rents, with the option to exit them from 23 September this year. Clearly with so much scope for horse-trading, the final terms come down, as it were, to the art of the possible rather than any sort of ideal for either tenant or landlord – which is why CVA stories tend not to have happy endings.

What really caught our eye in this particular tale, however, is the high rent-to-sales ratio of even the supposedly better stores as, here on The Value Perspective, we consider any such ratio above 10% to be a serious red flag. None of which is to suggest now is the time either to be buying or selling Carpetright – only that the company’s leases were a serious issue in 2014 and appear likely to continue being so.

Author

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials.  In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

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